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Using Price to Your Advantage

I’ve written a few pieces on the psychology of pricing recently, so now it’s time to turn to the business of pricing. The Price Advantage is definitely one of the best books on using pricing to create commercial advantage, and avoiding common mistakes that businesses make. While it doesn’t touch much on the psychology of individual customers it does provide a great overview and frameworks for thinking about pricing strategy and maximising profitability through price.

The key idea in the book (and for pricing strategy) is laid out in the first few pages, in a section the authors call “The power of 1 percent”. They start with data from 1,200 global publicly listed companies showing that their average fixed costs are 24.5% and their average variable costs 66.4%. A quick calculation shows that their average operating profit os 9.1%. Based on these numbers (indexed to 100), an increase of 1% in prices leads to a profit increase of 11% (at constant volume). Very small improvements in price can translate to huge increases in operating profit.

If you compare the impact of this change in price with that of other changes, the importance of price becomes even clearer. Compared with an 11% increase in profits from a 1% improvement in price,  a 1% improvement in variable costs yields a 7.3% increase in profits, a 1% improvement in volume leads to a 3.7% increase in profits and a 2.7% improvement in fixed costs leads to a 2.7% increase in profits. So why do so many companies fixate on costs and ignore the potential of price? In my recent article on the psychology of money, I wrote about how building emotional associations with your brand can lead to lower price sensitivity (i.e., a greater willingness to pay more for your brand). Of course, price is a double-edged sword and if your average price falls by just 1% then your operating profits can drop by 11%.

The authors focus on the price/volume trade-off is also interesting to read. Many companies believe that by lowering their price they can increase volume enough to generate more overall profit. The authors point out that this really doesn’t work in the real world. For example, a 5% decrease in price requires a 17.5% increase in sales volume just to break even. These are the economics of fantasy land as this would require a price elasticity of -3.5:1 to come true. Typically, price elasticities in most categories are under -2:1 (usually around -1.7 or -1.8). Such a high price elasticity is extremely rare, and the basic maths on price/volume trade-off really does not add up.

In the second chapter of the book, the authors usefully talk about three levels of thinking about price and pricing strategy:

  1. Industry strategy looks at supply, demand and cost in the context of the overall industry
  2. Product & market strategy looks at price and benefit positioning relative to competitors in your category or segment
  3. Transaction strategy looks at how you decide pricing for individual customer transactions (i.e., channels, base prices, discounts, adjustments, incentives, etc)

A useful tool for understanding more on these different levels is the “price waterfall” which they explain with examples (see below).

Another useful tool which they share is the value map, something I have myself used to understand when there are gaps between perceived value and price and actual value or price (i.e., looking at pricing research data versus market prices). This can be very instructive in understanding where brands or product lines have an advantage or disadvantage on value relative to their competitive set, and is really a very simple tool to use and understand.

The line where price is equal to perceived value (or benefits) is often called the Value Equivalence Line (VEL). Typically, new products (should) bring additional features and benefits to a category, and therefore should be priced higher than current pricing suggests. The authors point out that this a common error of new product launches, and that when errors are made in pricing strategy at product launch typically 80 to 90% of such errors launch the product at a price that is too low (and therefore more difficult to recover than if launched too high).

Later chapters focus on different aspects and scenarios for pricing, and I particularly liked the chapter on price wars. The authors soundly advise companies to avoid price wars at all costs. They point out that price cuts are almost always followed by competitors and that the only case for entering into a price war is if you have a very dominant cost advantage over your competitors (by which they mean costs that are at least 30% or more below those of your competitors).

Without such an advantage the impact of price wars are very harmful to business. Firstly, they can lead to large declines in profit (as explained above) and these declines are never offset by increased volume. Secondly, price advantages are usually very short-lived and just lead to the retention of share at lower price levels. Thirdly, they distort the expectations of consumers about price levels and such distortions tend to stick around for a long time. Fourthly, price wars make customers more sensitive to price and less sensitive to benefits (something that has happened in the PC and TV industries for most companies). For many companies, it makes much more sense to remain focused on selling your benefits rather than your price (and the psychology supports that this is the right strategy). This is the Price-Value Bias in behavioural economics – most customers focus on one or the other, but not both.

The Price Advantage is a great read for anyone who wants to better understand the commercial realities of pricing products and how to develop strategies to maximise business value. I recommend reading it alongside something on the psychology of pricing to understand who pricing works in the commercial world as well as inside your customer’s mind.

REFERENCE

The Price Advantage by Marn, Roegner & Zawada

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